Lower-than-expected demand at the auction — seen as a key test of emergency steps taken to control the euro zone debt crisis — pushed Italian bond yields higher and sparked a rally in safe-haven German debt.

The rise in yields, which nonetheless stayed well below levels hit before the European Central Bank began buying Italian debt three weeks ago, raised questions about the sustainability of Rome's funding efforts and threw the focus on to a Spanish bond auction on Thursday.

Traders said the ECB stepped in after the auction to buy significant amounts of 10-year Italian debt, halting the rise.

"The results look a bit worse than the market was expecting, with the 10-year looking weak with a rather small bid cover ratio," said Credit Agricole rate strategist Peter Chatwell.

"The market is likely to lose a bit of confidence from this auction until 10-year Italy stabilizes, which is in the ECB's hands."

The launch of a new 10-year benchmark bond drew bids worth 1.27 times the 3.75 billion euros sold, below the year's average bid-cover ratio on equivalent auctions of 1.4.

The ECB began buying Italian debt on the secondary market earlier this month in an unprecedented step to counter rising yields caused by investor concerns over the country's high debt levels and stuttering fiscal reforms.

The intervention brought benchmark 10-year yields down from levels well above 6 percent, seen as unsustainable, to around 5 percent. The current 10-year benchmark yielded around 5.14 percent in the cash market, up around 5 bps on the day.

The new 10-year bond sold at a yield of 5.22 percent, broadly in line with grey market prices ahead of the sale. That yield compared to 5.77 percent at an auction of the previous 10-year bond in July, before the ECB's intervention.

The auction will do little to alleviate the market's central fear that Italy, seen as too big to be bailed out, will not be able to issue bonds at an affordable level to finance its huge 1.9 trillion euro debt burden.

Italy must still sell up to 90 billion euros in bonds this year and ECB purchases have been steadily decreasing.

"The ECB support was clearly crucial. Without the ECB intervention a couple of weeks ago yields would not be trading at this 5 percent level so it might have easily been a full percentage point more," said Michael Leister, strategist at WestLB in London.

"The fact that yields remained relatively stable last Friday and more importantly this morning shows indeed that the ECB was successful in stabilizing them but the big question is what happens going further."

The ECB has bought around 43 billion euros worth of debt since it reactivated its bond buying program earlier this month, with market participants saying ECB buying has focused on Italy.

RAISING THE STAKES

A lasting resolution to the euro zone's debt crisis, which has so far claimed Greece, Ireland and Portugal, remains vital to easing pressure on Italy and Spain but is proving elusive.

Protracted wrangling over a deal announced last month to rescue Greece and expand the bloc's crisis-fighting toolkit threatens to undermine policymakers' efforts to date and keeps the pressure on the region's peripheral states.

"If there is concern that Greece is not going to be properly helped out... then Italy is clearly going to be in trouble as market are just going to say the euro zone is clearly non-functioning," said Monument strategist Marc Ostwald.

The nervousness in markets raises the pressure on Thursday's debt auction by fellow struggler Spain, which plans to launch a new 5-year benchmark with a 4 billion euro sale and whose bonds the ECB has also been buying.